This action might not be possible to undo. Are you sure you want to continue?
notice a kind of internal socialism present. The same problems of information, management and resource allocation that Mises and Hayek described in relation to socialist calculation will crop up. While many people think that firms exist to make money, in many cases they make money in order to exist and perpetuate themselves. This is in part because markets permit organizations that function just well enough to avoid bankruptcy to perpetuate themselves. Market discipline acts as a check on the expansion of badly managed firms, but it doesn’t magically guarantee results. That is up to the firm itself. There are in fact economic fallacies which disrupt firms and cause them to perform less efficiently. Two examples we’ll encounter in this essay are the labor theory of value and empiricism / pure induction. The largest problem is that the price system that enables cooperation in the market place does not always function as effectively as possible within firms. There is an entrepreneurial opportunity here for people to apply the lessons of Austrian Economics to firms and enhance their growth. It may also show people how Austrian Economics helps people understand not just how government policies make them poorer, but also how Austrian Economics can help directly improve their life. In short there is a great opportunity here for Austrian Economics to be applied in business. In this essay we’ll discuss an approach to making firms more profitable called Theory of Constraints or TOC. While this is not associated with the Austrian School, it is similar and parallel to it. Similarities between Austrian Economics and TOC Austrian Economics is a unified theory that helps people make sense of a wide variety of complex social phenomena and explain coordination and distortions in the marketplace. Theory of Constraints or TOC was designed to help members of firms, especially manufacturing firms, make sense of their own complex internal social phenomena and enable coordination and cooperation. TOC has detected certain flaws in the way actors in firms think, and their fixes for these flaws are congruent with the insights of Austrian Economics. Similarly the flaws within business thinking appear to be in part confusion but also erroneous ideas from economics that Austrian Economics and TOC corrects. Key linkages of Austrian Economics and TOC What is The Goal?
According to Austrian Economics the goal of market transactions is to make money and profits. The social function of the price system is to coordinate the different actors in the economy. According to TOC the goal of an organization is to make money, to profit. This goal must be used to coordinate the different actors within an organization. The Goal is also the title of the first book explaining TOC, and was written by Goldratt an Israeli Physicist. While one might think that obviously organizations make money, we have to remember that lots of businesses don’t make money, or very much of it. Many people within an organization have their own goals which aren’t necessarily aligned with the goal of making money. The organization just muddles through and often eventually goes out of business. Internally many organizations are run like bureaucracies or quasi socialist institutions. The organization needs a system to help coordinate everyone the way that the price system coordinates the market. TOC helps an organization align with the goal of making money. Just like the profit system helps actors in the economy align, TOC and the goal of making money can help employees in an organization align their efforts. The question is - how to make that coordination happen? The price system sends simple and clear signals across the marketplace. The goal of TOC was to figure out how to do create simple and clear signals for organizations. This would make coordination possible. The market system helps prevent the cascading effects of supply and demand variability. Similarly TOC helps prevent these effects within an organization. Many organizations in fact have serious difficulties meeting demand and buy excessive raw materials to prevent supply issues and experience cascading disruptions throughout the organization. Key Intellectual Errors Two key intellectual errors Rothbard cites in his history of economic thought are the Labor Theory of Value and Empiricism / Pure Induction. Similar errors seem to have infected business thinking in firms. These are also key errors that TOC seeks to address. Labor Theory of Value Accounting practice often treats inventory as assets that necessarily have economic value based on the value of labor input and the value of material. However as we know from Austrian Economics market value is based on there being a buyer available in the marketplace. Goods that can’t be sold don’t have value and aren’t an asset. In fact they destroy value. Inevitably firms who have unsold inventory eventually take a loss and write off the inventory, despite the inventory being valued as an asset. In the short term valuing inventory as an asset distorts production Accounting systems encourage many firms to produce goods at the lowest cost. This is often done by producing large batches of goods. Because the goods produced are seen as having some sort of inherent value, firms systems often do not consider whether there is
an immediate buyer. (Individuals at firms of course do see this is an issue, but the firms system don’t reflect this.) Additionally firms may buy large quantities of raw materials that can’t be immediately used in order to get a lower per unit cost. The raw material in inventory ties up scarce capital and may even be written off. In both cases what is in fact a cost – wasted inventories of raw and finished materials – is often seen as asset or way to save money. By contrast, TOC helps firms to devote all their production and buying towards producing for the market and what can be immediately sold. Empiricism / Pure Induction As Rothbard pointed out pure induction does not work. One does not simply sift through all the data to come up with conclusions. Goldratt, the author of The Goal and creator of TOC, points out that scientists view the data with the aid of a hypothesis, which is an IF THEN or statement. They don’t just sift through the data, they use the data to check their hypothesis and see if the data explains it. However many management system do not take in to account theory. They assume that collection of data is sufficient. TOC helps organizations understand what data is important and relevant. Accounting Systems Traditional accounting systems are also set up to deliver historical reporting. They allow firms to see over all what performance was historically. This is particularly useful for the state who wishes to collect taxes, and is useful for creditors. However accounting practices are not focused on helping entrepreneurs make decisions and deal with the future. These accounting systems think of inventory as assets and try to account for costs. However entrepreneurs are often dealing with costs that in the short term can be divided in to sunk costs and variable costs, but accounting system when historically reporting lump them together. This is explained in much detail in the TOC book The Measurement Nightmare by Debra Smith. Key Ideas of TOC related to Austrian Economics Entrepreneur The role of management in TOC is similar to that of Mises Entrepreneur. The Entrepreneur must determine what is the highest present use or investment of the capital available to him. This investment capital includes a variety of sunk costs as well as money available for investment. Entrepreneur uses the price system to help rank or value the different alternative courses of action available to them. TOC similarly helps people within the firm rank or value the different alternative courses of action available to them. Marginal Costs and Profits
In order to maximize profits TOC looks for those activities which can increase marginal profits today and over time. TOC refers to Throughput, which is marginal profit, or the price of the goods sold minus total variable cost (i.e. raw materials.) This emphasis on Throughput or marginal profits helps firms avoid activities that aren’t related to market demand. As we showed above, often companies will act in order to ‘decrease costs’ and not to increase profits. Time Production takes time and passes through various stages, each taking time This is a key point in Austrian Economics and in TOC. TOC focuses on stages of the production process and making sure that activities coordinate over time. As a corollary, it helps individuals understand the highest value action to take at each specific time. Many production processes are uncoordinated with disruptive shortages and surpluses at different stages of the production process. Firms are often at a loss as to how to deal with them because the different stages of the production process are not aligned. TOC helps firms align themselves. Profit Maximization and Sunk Costs A key idea is to maximize profits with the resources available to you. The available resources include sunk costs, like your machinery, buildings etc. as well as the labor, overhead, and vendor services which you’re going to pay for anyway at least in the short term. Your goal is to maximize your return on this investment by making the highest possible use at any given time. Therefore with TOC you want to maximize the use of resources, especially labor which you’re going to pay for anyway. It doesn’t help increase profits to ‘decrease costs’ on paper by using less of your resources on hand, just to decrease costs. Those resources are still there and their cost isn’t going away just because they weren’t used. Instead one should maximize the profitable utilization of the resources on hand. Unfortunately many firms don’t view sunk costs as sunk, and try to save on those costs, even though the costs are sunk. Profit Throughput and Opportunity costs One key idea is to look at your profit throughput per unit resource time. For example if you have a production line, how much money are you making per day or hour should be maximized. Often there is the temptation to reduce the cost of production by inappropriately minimizing the labor input, when in fact adding labor can sometimes radically increase the profit throughput. Sometime there is a huge opportunity cost to reducing a cost. In firms what is seen can trump what is unseen Profit Throughput also looks at the difference between your marginal cost of producing an additional good and the sales price of the good.
This helps answer - How do you prioritize production decisions? Companies who implement Theory of Constraints focus on selling and producing the highest value items. The highest value items are those items that have a ready buyer and produce the highest profits per unit of production time. Profit means the difference between the marginal cost and only the marginal cost of producing an additional good and the sales price of the good. This has the happy effect of increasing cash flow. This implies that if easy to produce low margin products have higher profit throughput than slow to produce high margin products, one should produce the low margin products. Producing high margin low labor products are not necessarily the best products for a firm to produce. Yet often companies assume that this is always the case. The Constraint TOC points out that in any production process there is a constraint or bottleneck. (Just as any basketball team always has shortest player.) This constraint limits profit throughput. Until the constraint moves, the organization must focus on the constraint. This helps coordinate everyone. The coordination system is fairly elegant and simple, just like the price system. Focus on maximizing profit throughput (which creates cash flow.) If the firms understand what actions and products maximize cash flow, this help coordinate everyone in the firm. Find the constraint in the business processes which if not running at peak performance will disrupt profit throughput. Focus on the constraint. This will help increase profit throughput. Don’t worry about other areas unless they’ll prevent from the constraint from running at peak performance. Other areas by definition aren’t the bottleneck and can pick up the slack. When the constraint moves to another place in the business process, focus on the new constraint. Conflict Management Debra Smith points out repeatedly in The Measurement Nightmare that actors within firms are often in conflict because the system sets up conflicting goals for different actors. Each person is trying to do the best job they can, but the system has given them conflicting goals. While the price system helps align firms, the system breaks down within the firm.
Similarly Mises Liberalism talks about the importance of Liberalism because it is a social system that aligns the individual and society. Under the Liberal system there is no structural conflict between the individual and society, and the price system is key part of Liberalism. Theory of Constraints works to set up a structure or way of thinking within the firm that aligns individuals and removes conflict. Further Reading Hopefully this helps show how applying better and more economic concepts to the firm can help increase firm performance. This essay is only scratching the surface. Two book which can help explain Theory of Constraints are The Goal: A Process of Ongoing Improvement by Eliyahu M. Goldratt and Jeff Cox The Measurement Nightmare: How the Theory of Constraints Can Resolve Conflicting Strategies, Policies, and Measures by Debra Smith The Goal is an easy to read novel which introduces reader to concepts using the Socratic method. It is the book that started it all. The Measurement Nightmare is a much more technical and slower work which analyzes the structural issues firms face and the TOC solution, especially those relating to accounting.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue listening from where you left off, or restart the preview.